Interest Rate Trends Inform LDI Approach

Liability-driven investing (LDI) strategies have been used
by defined benefit (DB) plans for decades, but gained steam with the passage of
the Pension Protection Act (PPA) of 2006, which increased penalties for
underfunded pensions, and the financial crisis of 2008, which reduced returns
on assets dramatically.

With increased volatility of the markets and low interest
rates increasing liabilities and the price of purchasing bonds, the question
is, is LDI still effective? Yes, say experts, who believe LDI is still a viable approach for derisking
DB plans.

According to October Three Consulting’s October Pension
Finance Update, October was a down month for investors, but pension sponsors
were able to tread water, as the impact of higher interest rates on pension
liabilities offset asset losses. Both model pension plans it tracks saw
basically flat results on the month. Through October, Plan A is down nearly 5%
and the more conservative Plan B is down nearly 1% on the year.

Stocks lost ground in October: A diversified stock portfolio
lost more than 2% during October but remains up more than 4% on the year.
Interest rates saw their biggest jump in the year in October, producing losses
of 1% to 2% on bond portfolios in October. For the year, bonds remain up 7% to
8%, with longer-duration bonds enjoying the best results.

Interest rates jumped more than 0.2% during October,
reducing pension liabilities by 1% to 2%. Rates have moved higher since hitting
all-time lows in July, but pension liabilities remain 8% to 12% higher than at
the end of 2015, with long-duration plans seeing the biggest increases.

NEXT: Considering the duration of bonds

Owais Rana, managing director at Conning, a global asset
management firm with $120 billion under management that advises corporate
pension funds, insurers, and other institutional investors, who runs the
investment solutions business that covers insurance, pensions and LDI, and is
based in New York City, notes that long-term low interest rates have resulted
in increasing liability values, and the market has been quite choppy. So if DB
plans are predominantly invested in equity, funding has been very volatile.

“The challenge is not that LDI hasn’t worked, the challenge
is DB plan sponsors want to derisk more, but they don’t want to buy bonds at
high prices,” he says. “If pensions were 95% to 100% funded, we would probably
see a lot more buying of long-duration bonds.”

Rana says those pension plans that were very-well funded and
adopted a highly engineered, customized LDI program years ago are in a much
better spot today.

Dan Westerheide, senior vice president and co-head of the
Data Asset Liability and Risk Management Group at Segal Rogerscasey in Boston,
says one of the components in adopting an effective LDI strategy is how to
position the duration of bonds. “For our broad set of clients, a component of
asset allocation is long-duration bonds to match liability duration,” he says. “While
most clients have not been 100% hedged by long-duration bonds, they have most
of their portfolios in long-duration bonds.”

With many plan sponsors in an underfunded position, there is
ongoing discussion about the right hedge ratio to match liabilities,
Westerheide adds. “Even though there has been a recovery in equities, interest
rates have continued to come down, increasing liabilities, so DB plan sponsors
continue to work away at underfunding,” he says. How much duration to use to
match liabilities revolves around interest rate levels, but the vast majority
of Segal Rogerscasey clients haven’t looked at the low-yield environment today
to justify reducing hedge ratios, according to Westerheide.

“Rates could go up from here, but the approach of most of
our clients is that, through analysis, they have determined what hedge ratio
should be,” he says. “In a disciplined manner they are getting there, and not
trying to time the markets.”

NEXT: Using triggers

Rana says those pensions that are underfunded and haven’t
adopted a full LDI strategy need to think about the ultimate objective if they
were fully funded. What investment strategy would they implement if fully
funded? With that target in sight, they should build a derisking glide path
that will take any unnecessary risk off table, he says. This may include equity
investments in some cases, but they should adopt investments that will match
liabilities and use triggers.

In an LDI strategy, many DB plan sponsors uses funding level
triggers—meaning when the plan reaches a certain funding level, the allocation
to equity and bonds will change. Rana says, DB plan sponsors could also have a
trigger that is based on long-term interest rate levels. “If buying at current
levels is too expensive, sponsors can set a target price for when they should
buy,” he says. “For example, if the 30-year Treasury bond rate reaches 3.5%, a
plan sponsor may decide to use that asset in its LDI strategy.”

Having triggers in place, DB plan investment committees will
have committed to LDI strategies with two objectives—they will use assets that
match liabilities but not locking in investments today, and as they become
better funded, they are going to derisk, Rana says.

With the volatility of the equity markets and the move in
bond interest rates, Westerheide says Segal Rogerscasey hasn’t seen a lot of
churning with glide paths. “Modest triggers are being hit and adjustments are
being made, but by and large the strong equity volatility and move in rates
more hasn’t resulted in a whipsaw of glide paths,” he says.

He adds that clients are not abandoning their LDI framework
even through what the markets are doing.

Rana adds that, “We’ve seen time after time that having
views on the markets can work sometimes but most of the time it hasn’t worked
that well, so DB plan sponsors need to take the human qualitative judgement out
of the administration of pension plans. Having a derisking path in place
fulfills what’s important in the market perspective as well as the risk
perspective,” he says. “What we advocate for is keeping the human judgement
element out of the equation. For example, if rates go up, some committee member
is likely to want to wait and see, but when the opposite happens, it hurts
pensions.”